The Capital Structure Decision and the Cost of Capital

Introduction

The theories of capital structure attempts to provide an explanation between the mix of securities and financing sources that may be employed by corporations to finance their real investments. Most of these theories have focused on the proportions of debt vs. equity as observed on the right-hand sides of the firms’ balance sheets

Advantages and disadvantages of debt financing

There are three most advanced advantages of debt financing in business. These include ownership maintenance, tax deductions and lower interest rate. Tax deduction form a huge attraction to debt financing because principal payments on the loans are classified as business expenses, thus can be deducted from business income taxes. However, a closer analysis reveal that there disadvantages with this form of financing. Assuming that a firm is financed through debt and equity, it has been advanced that borrowing will have a lot of implications on the firms cost of capital.

The chief reason why firms borrow seem to aggregate towards the fact that debt has a cheaper direct cost to equity and there are two distinct reasons for this; that is, debt is less risky to the investor than equity (low risks results in a low required return) and secondly, interest payments are allowable deductions against corporate taxations whereas dividends wont be. This does not mean that borrowing doesn’t have its limitations chief among which is the fact that it causes shareholders to suffer increased volatilities of borrowing of earnings, or what is commonly referred to as financial leverage. The implications of this are that borrowing may cause the cost of equity to rise and thus offsetting the cheap direct cost of debt. The other disadvantage is that too much borrowing may result in a firm going bankrupt. At reasonable levels of gearing this effect may be imperceptible, but becomes more poignant for highly geared companies as it may result in a range of risks and costs which have tendency to increase the company’s cost of capital.

Considering the case of a firm that has been financed by debt and equity alone, the company weighted average cost of capital (WAAC) will be computed using the cost of equity, the cost of debt and the market value of equity and debts as weights. Borrowing from the traditional view of capital structure, it has been suggested that when a firm starts to borrow, the advantages will outweigh the disadvantages. This is because the cheap cost of debt plus the tax advantage will cause the WAAC to fall as borrowing increases. However, as the gearing rises, the effects of the financial leverage cause shareholders to increase their expected rates of returns. At very high gearing the cost of debts also rises since the risk of the company defaulting on the debt rises in tandem, meaning that at higher gearing, the WAAC will increase. All these assumptions hold for perfect operating markets and where the risk free rate, company beta and cost of debt follow financial market fluctuations. However, significant variations will be discernible due to the magnitude of changes that have been triggered by the current credit crunch.

According to Armstrong (14), “the Optimal (target) Capital Structure is the Debt-to-Equity ratio of the firm which results in the lowest possible WACC (weighted average cost of capital)” The surveys of the optimal capital structure all seem to step from the Modigliani and Miller (12) assertions that financing doesn’t matter in the case of perfect capital markets. According to his model, the market values of the firmsrsquo; debt and equity, D and E should add up to the total firms value given that V is a constant. This proposition assumes that the assets and growth opportunities on the left hand side of the balance sheet have been held at a constant. This assumption results, to a large extent, in generalization of the mixes of the securities issued by the firm. For example, the debt period (whether long term or short term, callable or call-protected, straight or convertible etc) are not factored in the equations. This would also suggest that each firms cost of capital stands at a constant regardless of the debt ratio. Unfortunately, the capital markets are not sufficiently perfect. This is more so when we consider the effects of credit crisis in an economy.

General Dynamics

General Dynamics is a leading manufacturer in “business aviation; land and expeditionary combat vehicles and systems, armaments, and munitions; shipbuilding and marine systems; and mission-critical information systems and technologies” (General Dynamics, 1). The operating environment for this company will definitely be influenced by the economic realities of the specific times. An analysis of what would constitute a good capital structure points to a structure that results in a low overall cost of capital for a firm i.e. a low overall rate of return that must be paid back for the funds provided. This is structured around the understanding that when the cost of capital is low, the discounted value of future cash flows accruing to the firm is high which translates into higher overall value of the firm. Conversely, firms strive to find a capital structure that provides the overall cost of capital and, by extension the highest firms value (Armstrong, 27). According to the financial statements s of this company, General Dynamics has a debt to equity ratio of 31.1% as at 2009 down from 40.4 in 2005. The analysis of this company reveal that it is draws it financing from loans and equity.

The company’s Weighted Average Cost of Capital (WAAC) will be computed using the cost of equity, the cost of debt and the market value of equity and debts as weights. Borrowing from the traditional view of capital structure, it has been suggested that when a firm like this starts to borrow, the advantages will outweigh the disadvantages. This is because the cheap cost of debt plus the tax advantage will cause the WAAC to fall as borrowing increases. However, as the gearing rises, the effects of the financial leverage cause shareholders to increase their expected rates of returns. At very high gearing the cost of debts also rises since the risk of the company defaulting on the debt rises in tandem, meaning that at higher gearing, the WAAC will increase. All these assumptions hold for perfect operating markets and where the risk free rate, company beta and cost of debt follow financial market fluctuations. However, significant variations will be discernible due to the magnitude of changes that have been triggered by the recent credit crunch. Based on this analysis and the large size of this company, the optimal capital structure of General Dynamics should result to a low overall cost of capital for a firm. This can be best achieved by adjusting the debt financing upwards to cushion the company form effects of tax deductions due to its large size.

Sprint

Sprint is also characterized by its large size. In 2008, the giant firm made a loss of $29.76million. The capital structure of a firm plays a critical role in its performance. Leary (37) has pointed out that the impacts and implications of the capital structure of the firms, as eeither bank or non bank dependent, to be influenced by the relationship between the interest rates and the debt sources or debt issuance timing. It has been advanced for example that the ratio of the bank to non bank debt to be related to the interest rates (Diamond, 11), yet when its considered that interest rate movements are associated with changes in the availability of bank loans (Stein, 18), then the ratio of firm to non bank debt should be positively correlated with interest rates over the sample period as a whole (Cantillo and Wright, 99). These explanations directly point to the aspects of the capital structure of Sprint. It should however be noted that in the accompanying interest rates upsurges from the firm’s loans , the ratio of bank to non bank debts falls for small firms relative to large firms (Biger, 2),

It is seen that the bank dependent firms bear the costs of intermediation, but fluctuations in the bank’s access to loanable funds results in further variations in the firms financing decisions. It should also be noted that the effect of credit crunches is viewed to primarily affect the short term investment decisions (Leary, 93). Kashyap, Stein and Wilcox (19) as cited by Leary (97) has for example demonstrated that monetary policy shocks affects the mix of outstanding short term debt between bank loans and commercial paper as well as the inventory investment of small firms relative to larger ones. However, these credit crunches do impact on the long term investment decisions by firms, such as fixed investment, and automobiles purchases. These will definitely impact on the cost of capital. Armstrong (15) has advanced that one of the determinants of such investments is the size of the firm. The step for Sprint is to lower its debt financing and reduce on interests payable to service the debts.

Dell

Dell is a leading manufacturer of computer products. Financial markets require large firms like to hold capital as a cushion against contingencies and to protect creditors from agency costs of debts. In the context of this capital structure theory, a firm will hold that level of capital that will maximize the value of the firm within the unique advantages and constraints it may face (Athavale, Bland & Trimm, 1071). In making these investment decisions, and while focusing on particular utilities, three factors appear to reign Supreme, i.e., the high levels of uncertainties in the estimation of the forward looking financial figures, the increasing costs of access to debt financing, including that of reputable and stable institutions and the unusual effects difficult to factorize with the traditional approaches (Armstrong, 18).

The high level of uncertainties in the estimation of forward looking financial figures stems from the problems of estimating accurate values for the risk free rate, the corporate bonds credit spread and the corresponding gearing ratios. The increasing cost of debt also in the case of stable and reputable institutions has resulted from the shortage in credit supply and the lack of cheap financing sources. This has made it more difficult for the firms to determine the optimal capital structures from the traditional approach, largely due to the increases in risk aversions and the more extreme positions that are being taken by different stakeholders. This has meant that a lot of firms are struggling to arrive at the optimal cost of depth and capital structures. Dell has effectively managed to cushion itself against the capital structure uncertainties and as such, maintenance of the current capital structure would remain the best option for this firm.